Mid-year review

• US economic resilience has emerged as the primary driver of the US dollar's strength in mid-2026, with US data surprises versus the rest of the world reaching their widest gap in several years.
• The US dollar's breakout was catalyzed by Federal Reserve Chair Walsh's press conference, following a period where rate differentials failed to fully reflect the observed US economic outperformance.
• Technical indicators, including seasonality and chart patterns resembling 2018, supported a constructive view on the dollar heading into the third quarter.

US Rate Market Forecasts (Revised)

• Economists have revised the Fed view from cuts to three rate hikes within 2026, reversing previous "insurance" cut expectations.
  • The 2-year US yield forecast for end-2026 was raised by 60 basis points, moving from 3.9% to 4.5%.
  • The 10-year US yield forecast was adjusted upward by 25 basis points, moving from 4.25% to 4.5%.
  • These revisions imply a flat 2s10s yield curve at the end of the year.
• Long-term projections anticipate rate reductions after the 2026 hiking cycle, with the 2-year yield expected to fall to 4.25% by end-2027 and 4% by end-2028 as restrictive policy takes hold.
• The shift to a hiking cycle contrasts with unchanged forecasts for other major central banks, reflecting distinct underlying economic drivers in the US.

Global FX and Rate Divergence

• The European Central Bank (ECB) forecast remains unchanged at two hikes, with a notable risk that the September meeting could be skipped due to energy price dynamics.
• The Bank of England is now expected to hike rates zero times, leading to marginally revised down forecasts for sterling.
• Reserve Bank of Australia (RBA) is viewed as having completed its hiking cycle, with limited residual risk for an additional move.
• Bank of Canada (BoC) hikes are deemed unlikely due to struggling growth and trade negotiation uncertainty, suggesting US rates will outperform Canadian rates with a relative flattening of the US curve versus a steepening Canadian curve.

Dollar Trajectory and Time Horizon

• The bullish US dollar thesis is characterized as a specific trade for the third quarter of 2026, persisting until the Fed's hiking path is fully priced in.
• The Euro-to-Dollar forecast for Q3 2026 is set at 1.12, consistent with the historical beta of the pair to 2-year rate differentials.
• Long-term forecasts project a neutral dollar at 115 by end-2026, followed by a recovery to 120 in 2027.
• 2027 dollar weakness is anticipated to be driven by:
  • The fading of temporary US growth drivers, such as tax refunds, wealth effects, and the World Cup.
  • A projected global oil market surplus pushing prices to $60, which typically benefits non-US economies.
  • Potential growth convergence between the US and the rest of the world as global economies catch up.
• Contrarian signals are expected to emerge in Q4 2026 and 2027 as dollar positioning becomes extreme and strategic rebalancing away from US assets resumes among European investors.

Alternative Currency Themes

• Bank of America Global Research has shifted from bearish to neutral/bullish on the Japanese yen based on a fundamental balance-of-payments shift rather than valuation or intervention fears.
  • Foreign buying of Japanese equities has exceeded Japanese outflows for the first time in 12 months.
  • Inward Foreign Direct Investment (FDI) into Japan is increasing as corporate outflows moderate.
  • A constructive view requires further evidence of prudent Japanese fiscal policy to complement the improved capital flow dynamics.
• Summer carry trade strategies are recommended for the remainder of July but cautioned against for August due to typical underperformance and volatility spikes during the post-summer period.
  • The Swiss Franc is identified as the most attractive funding currency for volatility-adjusted carry strategies.
• Volatility in the GBP/USD (cable) pair is currently undervalued and expected to rise ahead of US midterm elections and the UK budget.
  • This pair screens as a cheap hedge opportunity for the upcoming election and fiscal events.